A. What is churning? Excessive Customer Trading (“Churning”) is a short-hand expression intending to refer to a complex type of securities trading where a Firm and/or one of its registered representatives who controls the volume and frequency of trading in a customer’s account, abuses the confidence and trust of their customer, and initiates trades that are excessive in view of the financial situation and investment objectives of the customer.  Churning occurs then, when an account executive recommends or effects transactions which are excessive in cost, size or frequency, without regard to the customer’s stated risk tolerance and previous investment history. Often it includes the excessive trading of low quality speculative stocks, traded frequently, with low spreads between buys and sells. This is especially seen when the stocks are ones in which the broker makes a market or specializes.  It is settled that when a broker, unfaithful to the trust of his customer, churns an account in the broker’s control for the purpose of enhancing the broker’s commission income in disregard of the client’s interest, there is a violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. s 78a et seq., and Securities and Exchange Commission Rule 10b-5.  Churning can result not only in customer complaints, but in regulatory proceedings, fines and sanctions (including suspensions or an industry bar).


B. Incentives to churn – Competition forces a demand for higher production. Further, broker dealers offer higher incentives and promotions to big producers. There are also factors of greed and fear.


C. There are 3 factors involved in a churning case. These are control, scienter and excessive trading.

1. Control – It is important to determine whether the broker controls the investment decisions in the account. The account does not have to be discretionary for control to exist. Thus, a broker dealer can still be liable for churning, even though the account was not formally a discretionary account.

 Standard of practice – If it is found that the client followed the broker’s recommendations in most transactions, it is generally held to be sufficient.

 De facto control – This is indirect demonstration of control. In the Mihara case and Hecht v. Harris Upham & Co. N.D. Cal. 1968 – “The requisite degree of control is met when the client routinely follows the recommendations of the broker.” This is de facto control by the broker. Therefore, control can be implied when a stockbroker possesses overwhelming influence over an unsophisticated customer.  The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject  one when he thinks it unsuitable.  An interesting method of determining control through trading patterns can be observed by examining confirmation slips and monthly statements for disclosure as to whether a number of transactions were “unsolicited” by the stockbroker, meaning, that the customer ordered many of the transactions without ever having had the securities called to his or her attention by the stockbroker.  There are ten principal elements or characteristics that help determine if de facto control exists in a broker-customer relationship.  These were listed in a 1978 book by Stuart Goldberg entitled “Fraudulent Broker Dealer Practices”.  They are:  1.  Sophistication of the customer.  2.  Prior securities experience of the customer.  3.  Trust and confidence placed in the stock broker, by the customer.  4.  Percentage of transactions entered into by the recommendation of the stockbroker.  5.  Amount of time devoted to independent research by the customer.  6.  Acquiescence by the customer, when knowledgeably made and after full disclosure in recommendations made by the stockbroker.  7.  Customer’s prior approval of transactions.  8. Contemporary brokerage accounts in more than one firm.  9. Truth and accuracy supplied by the stockbroker 10.  The economic rationale and suitability of the trading strategy if recommended by the stockbroker.

      In addition to the above, it is always important to analyze the dominance of the broker over the customer, which is really a conclusion based on the above factors.  The SEC has thus noted the customer’s inability to understand the difference between how a margin account or options work, or the effect of the ex-dividend date on the price of a security. A finding that the customer had difficulty in understanding the investment advice given to him, even when the broker tried to explain it, is particularly relevant. These inadequacies tend to make the customer dependent on his broker.  The mere fact that the customer approves the trades and receives confirmations does not prove ratification of churning activity.  In Hecht v. Harris Upham, it states, “The Court concluded that while confirmation slips were sufficient to inform plaintiff of the specific transactions made, they were not sufficient to put her on notice that the trading of her account was excessive.”  The fact that a customer received confirmations and monthly statements will not defeat establishment of control over the account where such documents are beyond the comprehension of the customer or the broker reassures the customer after receiving complaints.

 2. Scienter – The intent to defraud or reckless disregard of the customer’s best interest by the broker. M&B Contracting Corp. v. Dale – 6th circ. 1986 – Also, Mihara v. Dean Witter (Landmark case). “The churning of a clients account is, in itself, a scheme or artifice to defraud within the meaning of 10b-5. The evidence in Mihara reflects, at the very minimum, a reckless disregard for the clients stated interests.”  See Franks v. Cavanaugh, 711 F. Supp. 1186 (S.D.N.Y. 1989) (“scienter element of churning may be inferred from an annual turnover rate in excess of six.”).  The element can be met by a showing that the broker in control of a customer’s account traded the account excessively for the purpose of generating commissions and acted with intent to defraud or at least with willful and reckless disregard of the customers best interests.  When there is a fiduciary duty to the defrauded party, recklessness can suffice for the necessary scienter.  Armstrong v. McAlpin, 699 F.2d 79 (2nd Cir. 1983); In re Inserra, SEC Admin. Proc. File No. 3-6691, [1988] Fed. Sec. L. Rep. (CC) #84,334, at 89,499 (Sept. 30, 1988) opinion of administrative law judge).

      The “scienter” element element can be satisfied by knowing or reckless conduct, without showing a willful intent to defraud.  Vernazza v. S.E.C., 327 F.3d 851,860 (9th Cir. 2003).  Reckless conduct may be defined as highly unreasonable omission, involving an extreme departure from the standards of ordinary care, and which presents a danger of misleading that is either known to the defendant or is so obvious that the defendant must have been aware of it.  Hollinger v. Titan Capital Corp., 914 F.2d 1564,1569 (9th Cir. 1990).  The danger of misleading buyers must be actually known or so obvious that any reasonable man would be legally bound as knowing.  Id at 1569-1570.  A showing of recklessness is an appropriate standard when the broker is in a fiduciary relationship with the client.  Rolf v. Blyth, Eastman Dillon & Co. Inc., 570 F.2d 38,44 (2nd. Cir. 1978).


1989 NASD Manual – Art. III, Sec. 2 #2152.10 – “It is not necessary to show scienter in order to establish excessive trading under the NASD Rules of Fair Practice.” SEC Release No. 34-20376 (1983). Art. III, Sec. 3 #2152.49 – “No finding of scienter is necessary to show violations of NASD rules”. Eugene J. Erdos v. SEC, No. 84-7033 (9th circuit, 1984).


3. Excessive trading – The determination of excessive trading varies from account-to-account and only can be considered in light of the nature of the account, and the needs and objectives of the customer.  The hallmarks of excessive trading are disproportionate turnover of the account, frequent in-and-out trading, and large brokerage commissions.  “In-and-out” trading may also be an indication of excessive trading.  A pattern of selling stocks quickly after purchase, before any real price change is often indicative of churning.  As the Securities and Exchange Commission (“SEC”) has recognized, “excessive trading represents an unsuitable frequency of trading and violates NASD suitability standards”.   Paul C. Kettler, 51 S.E.C. 30,32 (1992); see also Harry Gliksman, Exchange Act Rel. No. 42255, at 4 (Dec. 20, 1999); Michael H. Jume, Exchange Act Rel. No. 35608. at 4 n.5 (April 17,1995): Rafael Pinchas, Exchange Act rel. No. 41816, at 10 (Sept. 1, 1999).  Even in cases in which a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customers financial profile.  (emphasis added)   See Pinchas, supra, at 11 (customer’s desire to “double her money” does not relieve registered representative of duty to recommend only suitable investments); Jphn M. Reynolds, 50 S.E.C. 805,809 (1992) (regardless of whether the customers wanted to engage in aggressive and speculative trading, the representative was obligated to abstain from making recommendations that were inconsistent with their financial situation).  In re. Frederick c,. Heller, Rel. No. 34-31696, January 7, 1993:  A customer’s wealth certainly “does not provide a basis for engaging in excessive trading in his account citing In re Arthur Joseph Lewis.  In re. Eugene J. Erdos, Rel. No. 34-20376, November 16, 1983:  Even though Mrs. C. may have desired ‘quick profits’ that did not entitle Erdos to ignore her individual situation and place her limited assets in risky investments.  Whether or not Mrs. C considered the transactions in her account suitable is not the test for determining the propriety of Erdos’ conduct.  Citing Phillips & company…Even assuming that Mrs. C’s objective was to make quick profits, the activity in her account was clearly excessive in the light of her financial situation.  And the fact that Mrs. C. may have authorized the transactions in her account does not alter that conclusion.


a. Qualitative factors


Investor objectives

Investment strategy – clients understanding and evaluation of strategy

Aversion to risk


b. Quantitative factors


         Cost/Equity Maintenance Factor – Annualized


         Turnover Ratio – Annualized


Cost to Equity – Simply a determination of the percentage of return on the customers average net equity in order to pay broker-related commissions and costs.  These costs include commissions, fees, mark-ups, mark-downs, selling concessions and margin interest.  In other words, any compensation that drives the trade.  The question to ask is whether the broker would have sold the security if not for the compensation!  Michael David Sweeney, SEC Release No. 34-29884 (October 30, 1991).  See also Shearson Lehman Hutton, SEC Release No. 34-26766 (April 29, 1989). “A primary test for excessive trading is the relationship between the net amount of money invested and the transaction costs that are incurred.” See McCann, Craig, and Richard G. Himelrick, “Spreads, Markups, Sales Credits and Trading Costs, “PIABA Bar Journal, Summer 2002, for an explanation of calculating trading costs.  For the purpose of calculating break-even analysis (BER) however, the only relevant “commission” is the cost to the customer, which equals any agency commission plus the spread and/or slippage on the trade.  Because of the difficulties in determining historical spreads, the commission credit paid to the broker is commonly used as a reasonable approximation of the cost to the customer.


As a general rule, in a conservative investment account, an inference of excessiveness will come about with a cost/equity maintenance factor of four percent and a turnover rate of two times; a presumption would be raised when the respective formulas result in findings of C/E of eight percent and a ATR of four times; and a conclusion might be reached at levels wherein the cost/equity maintenance factor is twelve percent and the annualized turnover rate (ATR) is six times.


Turnover ratio – Total cost of purchases divided by the average net equity.  This shows the number of times that the total purchases in the account exceed the average net equity.


A. New York Bankruptcy court, re: Thomson Mckinnon Sec. Inc. 1996 WL 60480 “In determining that a 2.22 turnover ratio presented evidence of churning, the court cited a 1990 study which found that the turnover ratio of even the most aggressive mutual funds is 1.18, while more conservative funds’ turnover is .58.” (Winslow & Anderson, A Model for Determining the Excessive Trading Element in Churning Claims), 68 N. Ca. L. Rev. 327 [1990]).  Walter S. Grubbs, Release No. 34-4138, July 30, 1948 (a turnover of 2.5X in 3+ years was found to be excessive.)  In re. R.H. Johnson & Co., Release No. 34-4694, April 2, 1952 (Chart showing turnover rate over five (5) years:  1944 – 2.35X, 1945 – 3.29X, 1946 – 1.99X, 1947 – .83X, 1948 – .82X  held excessive).  Gerald E. Donnelly, Exchange Act Rel. No. 36690, 61 S.E.C. Docket 31 (January 5, 1996) (turnover rate ranging between 3.7 and 4.4 was excessive).


B. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Burke, 741 F. supp. 191, 192-194 (N.D. Cal. 1990) The court affirmed an arbitration award based on a 4.4 to 1 turnover ratio.  Gerald E. Donnelly, Exchange Act Rel. No. 36690, 61 S.E.C. Docket 31 (January 5, 1996) (turnover rate ranging between 3.7 and 4.4 was excessive).


1. Stuart Goldberg – Former President – Public Investors Arbitration Bar Association (PIABA)


                             Turnover Rate:                                                       Cost to Equity Maintenance Factor


2 – Possibility of churning (excessive for conserv. accts.)          4% –  Possibility of churning (inference)

4 – Presumption of churning (excessive for regular accts.)        8% –  Presumption of churning

6 – Presence of churning (excessive for speculative accts.)    12% –  Presence of churning


2. Churning by Securities Dealers – Harvard Law Review – 869 (1967) “The turnover ratio (ATR) is the “litmus test”. An annualized turnover ratio of greater than 6 is likely to be excessive. The objective measure of ATR is to be evaluated with the subjective measure of the investor’s investment objectives”. Some courts have held that an annual turnover rate of over six is per se excessive.  Craighead v. E.F. Hutton & Co., Inc., 899 F.2d 485, 490 (6th Cir. 1990). Berg, Howard G. and J. Julie Jason, “Does the Literature of Churning Reflect the Current State of the Brokerage Industry?”  Securities Arbitration 1996, Volume Two, Practicing Law Institute, 1996.  “Analyzing ATR in terms of industry norms from 1947 through 1996, as well as how it has been interpreted through the decades, the shrine that has been erected around the magic number of 6 should be dismantled and the benchmark lowered to a suggested level of 3”.


3. Mihara v. Dean Witter: While there is no clear line of demarcation, courts and commentators have suggested that an annual turnover rate of 6 reflects excessive trading.   Kaufman v Magid (1982, DC Mass) F Supp 1088, CCH Fed Secur L Rep P 98713: 6 times. Arceneaux v Merrill Lynch, Pierce Fenner & Smith, Inc. (1985, CA11 Fla) 767 F2d 1498, CCH Fed Secur L Rep #92247: 8 times.  Shearson, Lehman, Hutton, Inc. 49 S.E.C. 1119,1122 (1998) (turnover rate of 7.4 was excessive).


4. See Rolf v. Blythe Eastman Dillon, Churning by Securities Dealers, Harvard Law Review (1967) and Hecht v. Harris Upham N.D. Cal (1968, DC Cal) 283 F Supp 417, affd. 9th dist. ‘70: “This court affirmed a finding of churning where an account had been turned over 8 -11.5 times, during a six-year, ten-month period.”


— 45% of the securities were held for less than 6 mos.

— 67% of the securities were held for less than 9 mos.

— 82% of the securities were held for less than 1 year.


5. Mihara v. Dean Witter: 1971.


— 50% of the securities were held 15 days or less.

— 61% of the securities were held 30 days or less.

— 81.6% of the securities were held 180 days or less.

 Trading activity

 Frequency or number of trades –

 – Mihara v. Dean Witter: 15+ trades per month raises the specter for supervision and compliance to determine churning.  UBS PaineWebber has a minimum of 15 trades or $4,500 in commissions to trigger an Active Account Analysis & Review.

 – Industry custom and practice: 10 trades per month is generally acceptable.  15 trades per month will typically trigger management to send an activity account letter to the client.  This analysis was initiated by the Dean Witter computer whenever an account showed 15 or more trades in one month or commissions of $1,000 or more.   Mihara v. Dean Witter Nos. 78-2022, 78-2729 U.S. Court of Appeals, Ninth Circuit. May 23, 1980

 Cost to Equity –

 – Costs in excess of 5% of account equity should be seriously questioned by any customer.  This is because a low load mutual fund can be purchased for 3%-5%.  Further, any managed or wrap account typically carries with it an overall cost of 3.5% – 4.5% annually, when all transaction costs are considered. These industry benchmarks should be compared to the clients annualized cost to equity maintenance factor.  According to one court, “Turnover rate is but one indicia of churning.  One authority has suggested a more meaningful computation and one more readily comprehensible to investors as well; the percentage of return on the investor’s average net equity needed in order to pay broker-dealer commissions and other expenses*.  This figure, termed “The Goldberg Cost Equity Maintenance Factor,” amounts in essence to a sales load.  Jenny v. Shearson, Hammill & Co. 1978 Fed. Sec. L. Rep. (CC) #96,568 (D.C.N.Y. Oct. 6, 1978)(citing S. Goldberg, Fraudulent Broker-Dealer Practices, #2.9(b){5}(Am Inst. for Sec. Reg. 1978).  *S. Goldberg, Customer Recovery, supra bite 32 at 15.  Mr. Goldberg uses the following example:  For example, suppose a customer has a securities account valued at $50,000 and the stockbroker’s commissions for one year are $20,000.  What this means is that the customer’s account must earn a rate of return of 40% per year just to meet expenses.  Thus, in this example, the Goldberg : Cost/Equity Maintenance Factor is 40% (emphases in original.)   Michael David Sweeney, 50 S.E.C. 761 (1991) (excessive trading where customers would have had to earn returns of 22% to 44% to break even); and Shearson,  S.E.C. 1119, at 1121 (excessive trading where customer would have had to earn return of 50% to break even).  Berg, Howard G. and J. Julie Jason, “Does the Literature of Churning Reflect the Current State of the Brokerage Industry?”  Securities Arbitration 1996, Volume Two, Practicing law Institute, 1996 – “In view of expected performance over time…commissions of about 5% to 6% annually in a brokerage account with a growth and income or conservative investment objective over which a broker exercises control is probably about the limit the account can bear.”


Cost to Equity in Options Accounts –


     Report of Special Study of the Options Markets to the SEC (December 22, 1978 – The Options Study of 1978 was critical of the use of ATR in an options account, reasoning that short options that expired would be reflected in the calculation.  However, any such effect would almost always be very small; moreover, it would only serve to understate the customer’s turnover calculation, thereby making it conservative.  The Study came down squarely in favor of the use of a commission-to-equity ratio of which BER (break-even ratio), which includes margin interest, is a logical extension, as a means of evaluating accounts for excessive trading.  Usually, however, the options debate is more qualitative than quantitative, arguing that options are by design short-term instruments and that a higher turnover rate is expected.  Here again, the use of BER will create the rebuttal for the argument:  the harm in frequent trading is the cost.  BER allows us to to look at the cost of trading in an options account and evaluate whether it was suitable for the customer in question.  A number of SEC releases support the premise that the cost-to equity ratio is the appropriate measure for analyzing an options account for churning.


D. How have damages been calculated?


Stockbroker “Churning” Liability by Ferdinand S. Tinio, LL.B., LL.M. 32 ALR3d 635 “The liability of a broker or dealer for damages is another troublesome aspect of an action for churning. One view is that the broker is liable for the commissions or other profits which he earned from the excessive trading, while another view is that the broker or dealer must pay to the victimized customer the difference between the probable value of the account if it had not been improperly handled and its actual value after it had been churned”.


in Hatrock v. Edward K. Jones & Co., 750 F. 2d 767 (9th Cir. 1984), the Court held that the investor may recover excess commissions charged by the broker and decline in the value of the investor’s portfolio resulting form the fraudulent transactions.  Id. at 773-74.  The calculation to determine the decline in the value of the account is “the difference between what [the plaintiff ] would have had if the account had been handled legitimately and what he in fact had at the time the violation ended.”  Id. at 774.  See also In re Faulhaber, 269 B.R. 348 (W.D. Mich. 2001) (same).


See also Laney v. American Equity Investment Life Ins.,243 F. Supp. 2d 1347 (M.D. Fla. 2003).  In Laney, the Court held that in a churning case, the plaintiff’s damages are the commissions paid by the customer and benefit-of-the-bargain damages.  Benefit of the bargain damages are the amount the poaintiff would have had if his account had not been managed fraudulently, less the amount the plaintiff actually received. 1355.


See also Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 S.W. 2d 1206 (8th Cir. 1990).  In Davis, the plaintiff’s account was churned.  In assessing damages, the appellate court agreed with the district court that [the customer’s] compensatory damages, even though the account showed an overall profit,  were:


     (1)      Commissions paid to defendant in connection with the unauthorized trades or the churning; and


     (2)      Loss of value of [the customer’s] account or the out of pocket loss suffered by [the customer].  This amount would be the value that her account would have had if there had been no unauthorized trades or churning, less the amounts she actually received, including both the value of the account and the [money] paid her by the defendant.


Mihara v. Dean Witter & Co., Inc. 619 F.2d 814 (9th cir. 1980)


Miley v. Oppenheimer & Co. 637 F.2d 318, 326-27 (5th cir. 1981)


Courts awarded:


— Return of commissions earned


— Margin interest paid

— Decline in the account


— Earned interest

— Punitive damages


Nesbit v. McNeil and Black & Company, Inc., 896 F.2d 380 (9th cir. 1990)


Courts of appeals awarded:


— Damages, even though the investor’s accounts showed an overall profit.


Churning is not excused by the fact that the account realizes a net profit.


E. Who is responsible for liability in a churning case?


Stockbroker “Churning” Liability by Ferdinand S. Tinio, LL.B., LL.M. 32 ALR3d 635 “The liability for churning a customer’s account is not limited to the acts of the broker or dealer alone. Thus, in large securities-brokerage firms with many salesmen or with branch offices in several cities, the managing partners or other top officers cannot escape liability for the acts of their individual salesmen, in the absence of a showing that those salesmen were closely supervised in their activities”.   Further, that supervision must be in place to “prevent violations”.


In many instances, the monthly statement that is produced by the brokerage firm contains, in the extreme right-hand corner, cumulative information regarding all of the commissions, selling concessions, and mark-ups/downs in the account both for the month and year to date.  Regrettably, this portion of the monthly statement is ripped off before the statement is transmitted to the customer i.e. the great brokerage statement rip-off!  The brokerage firm is clearly part of the mechanism that prevents the customer from ever learning of the compensation charged to his or her account.  This lack of disclosure clearly places responsibility of churning squarely on the brokerage firm.  Customers are simply not informed that they can insist that their brokerage firm supply an unaltered monthly statement or separate commission payout run.  Further evidence of supervision liability can be shown in a great number of arbitration decisions where the award is joint and several against the broker and the firm.


F.  Churning and other violations in Managed Accounts –


     There are a host of factors that could motivate an unscrupulous broker to actively or excessively trade a flat fee account.  They include markups, markdowns, spreads and margin interest.  There may also be soft dollars or payments for order flow that make it profitable for a managed account to be actively traded.  Further, flat fee agreements usually contain limitations on the number of trades that get the benefit of the flat fee, after which commissions and additional fees kick in.  NASD Notice to Members 03-68 describes several ways in which representatives and their firms can violate securities rules.  They are:


     *     NASD Rule 2110: It is inconsistent with just and equitable principles of trade for a rep to place a customer in a fee structure that can be expected to result in a greater cost to the customer than an alternative fee structure providing the same services and benefits.


     *     NASD Rule 2310:  A recommendation otherwise suitable for a customer can be rendered unsuitable if another fee structure would have provided a pecuniary advantage to the customer and


     *     NASD Rule 2430:  All charges for services must be reasonable and fair for each customer for each transaction.


     In August, 2005, the NASD fined Morgan Stanley $1.5 million and ordered it to pay $4.6 million in restitution to 3,549 investors.  The charge:  failing to monitor investors in fee based brokerage accounts, which usually cost a percentage of the assets being managed, to see whether these investors would be better off paying commissions.  Morgan Stanley, in settling the matter, didn’t admit or deny guilt.  But the firm, along with others under the regulatory spotlight, is changing its policies to give investors more information about the fees they’re paying and the services that they’re getting in return.


NOTE: Margin interest and option trading, two factors that complicate the churning process, are only briefly considered here.  SEC rulings have clearly shown that the Cost to Equity Maintenance Factor should be the controlling churning ratio as opposed to the Turnover Rate.  This is because options and margin trading necessitate much greater activity than normal, as a general rule.


Mason A. Dinehart – Financial Education Network Development – October 4, 1997, updated 1-20-03 and 12-17-03.


                                      EXCESSIVE TRADING IN CHURNING CLAIMS


                                                     Mason A. Dinehart – 2-15-01*




     Excessive trading is commonly found in accounts which have turnover ratios of less than six ( the 1967 Harvard Standard), but which have more conservative investment objectives.  Thus, a turnover ratio of 2 might be excessive in the account of a customer with conservative investment objectives but not excessive in the account of a customer with speculative objectives.


     Financial markets have progressed dramatically over time.  Commission rates are no longer fixed and there has been a proliferation of securities such as options, futures, specialized mutual funds, unit trusts and other proprietary products.  In response to these developments, Winslow and Anderson (“A Model for Determining the Excessive Trading Element in Churning Claims”) argue in favor of a different standard for judging whether an account has been excessively traded.  They suggest that the proper standard of comparison is the turnover of a group of mutual funds with investment objectives similar to the customer in question.


     Winslow and Anderson argue that the turnover in professionally managed accounts such as mutual funds is driven solely by professional judgment and not the desire for commissions.  Brokers hold themselves out as financial experts and also earn commissions when securities are traded.  Thus, it is relevant to compare turnover ratios associated with brokers who have a potential conflict of interest to the turnover ratios of professionals who have no conflict of interest.


     Winslow and Anderson find average turnover rates for stock mutual funds which range from about .5 for the most conservative group of funds to 1.18 for aggressive growth funds.


     Given that professional money managers turn over their portfolios an average of less than one time per year, the Harvard Standard of a turnover ratio of six for presumptive excessive trading appears overly generous to brokers.  This is especially true when it is noted that retail securities customers pay much higher commissions than institutions such as mutual funds.  Institutional commissions for large transactions are in the range of 5 to 10 cents per share.  Retail securities accounts, in the alternative, pay commission rates in the range of 25 cents to one dollar per share.


     Until recently, the 2-4-6 turnover formulation suggested by Goldberg has been the most often cited standard for excessive trading activity.  A common interpretation of this formulation is that a turnover of 2 is excessive for conservative accounts, 4 is excessive for regular or moderate accounts and 6 is excessive for aggressive or speculative accounts.


     Winslow and Anderson argue against rigid standards and suggest that it is relevant to look at the turnover ratios of mutual funds with similar investment objectives.  Their conclusions are highlighted in the following passage:  “Depending to some extent on the specific investment objectives as reflected in the mutual fund data…., an appropriate annual turnover rate should be seen as lying in the neighborhood of one; rates increasing beyond one, the broker should bear the burden of explaining the higher than normal rate.  Once the rate rises to about three, there should be little room for argument about the excessive trading element of the claim”.


     Thus, Winslow and Anderson suggest a loose 1-3 formulation where the burden is on the broker to justify a turnover in excess of one and a turnover of three is strongly suggestive of excessive trading.


     The looser 1-3 formulation suggested by Winslow and Anderson can be associated with Commission to Equity ratios (C/E) and Total Cost to Equity ratios (TC/E), the latter adding margin interest to commissions, fees, markups/downs and selling concessions (i.e. elements of compensation that “drive” the trade).  This fact is recognized in NASD Notice to Members 99-90 (The Discovery Guide – November 1999) when a churning case requires that the Firm/Associated Person(s) produce in discovery, “all documents reflecting compensation of any kind, including commissions, from all sources generated by the Associated Person(s) assigned to the customer’s account(s) for the two months preceding through the two months following the transaction(s) at issue, or up to 12 months, whichever is longer”.  Any compensation that motivates the trade is considered!


     The interpretation of the C/E and TC/E ratios as the minimum rate of return necessary to cover annual account costs is suggestive of another standard of comparison for excessive trading which could be applied.  The standard is the rate of return which can be consistently earned on different classes of securities.  If costs in the account are such that the possibility of consistently earning a positive rate of return are low, then it is reasonable to suggest that costs are excessive.  Ibbotson Associates (Stocks, bonds, bills and inflation, 2000 Yearbook, Chicago 2000) report that the arithmetic average annual rate of return on the common stocks in the S&P 500 composite index from 1926 through 2000 was approximately 11%.  This annual rate of return includes both price changes and any dividends which were paid on the securities in the index.


     The actual returns on stocks in any particular year may vary substantially from their long term averages.  In the long run, however, it is to be expected that average return of stocks and bonds in the future will approximate this number.  If an account is turned over 3 times, and has annual costs in the neighborhood of 11 percent, and since the long term average return on stocks is about 11%, there is little reasonable expectation that such an account could consistently earn a positive rate of return for the customer.  It is reasonable to assert that such an account was excessively traded.  The Winslow and Anderson suggestion that a turnover of three is excessive in most cases appears to be entirely sensible in light of the typical costs of such a turnover rate and the long run expected return on common stocks.


     It therefore seems sensible to conclude that if an account is turned over three times or more annually and costs are such that there is little reasonable expectation that the account could consistently earn a positive rate of return i.e. 11%+, then the burden should be on the brokerage firm to justify the trading conducted.


*  Sources:


     1.  North Carolina Law review (Volume 68, Number 2 January, 1990) Donald Arthur Winslow, Asst. Professor of Law, Univ. of Kentucky.  A.B. 1975, Univ. of Calif. at Los Angeles; M.B.A. 1979, Cornell Univ. Seth C. Anderson, Asst. Professor of Finance, College of Bus. Auburn Univ. B.S. 1969, Univ. of Alabama; M.B.A. 1980, Auburn Univ.; Ph.D, 1984, Univ. of North Carolina.


     2.  Securities Arbitration 1991 – Practising Law Institute (PLI) corporate Law and Practice – Course Handbook Series, Number 742; Quantitative Measures and Standards of Excessive Trading Activity – Stewart L. Brown, May 13,1991.


     3.  Harvard Law Review, Volume 80 1966-1967 – The Harvard Law Review Association, Cambridge, Mass.


     4.  Arbitrator Source Book to Stockbroker Fraud and Securities Arbitration – Stuart C. Goldberg (1991)




                                              SIX YEAR ELIGIBILITY RULE




     It is well settled that the arbitrators and not the courts decide the eligibility of claims in arbitration. The Six Year Eligibility Rule is found in FINRA Rule 12206, which states that no claim shall be eligible for submission to arbitration under the Code “where six years have elapsed from the occurrence or event giving rise to the claim”.  This rule is virtually identical to its predecessor rule, NASD Rule 10304.   Rule 12206, FINRA’s “six year eligibility rule” does not start automatically on the transaction date.  This is because numerous cases have held that the eligibility period begins running when the cause of action “accrues” i.e., when a case first can be brought.  That date often differs from the date of the transaction.  Appellate decisions from federal circuits have adopted the view that it is the accrual of a cause of action that starts the six-year eligibility period with respect to that cause of action.  In other words, the purchase date is not dispositive.  PaineWebber, Inc. v. Hofmann   984 F.2d 1372 (3d Cir. 1993); Osler v. Ware  114F.3d 91 (6th Cir. 1997); Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Lauer  49 F.3d 393 (7th Cir. 1995); J.E. Liss & Co. v. Levin,  201 F.3d 848 (7th Cir. 2000); Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cogswell   78  F.3d 1001 (11th Cir. 1997).  In Kidder Peabody v. Brandt, the court stated as follows:  Therefore, we reject Kidder’s interpretation of the “occurrence or event giving rise to the …claim” language of Section 15 [now known as “Rule 12206”].  Instead, we hold that under Section 15 the “occurrence or event” which “gives rise to the   …   claim” is the last occurrence or event necessary to make the claim viable.


     While there are only a few cases decided by FINRA arbitrators interpreting the 6 year rule, the decision in C&H Properties, Inc. v. Morgan Keegan Company, Inc., FINRA Case No. 11-00263 is instructive.  There, the Court stated:  a.  FINRA Rule 12206(a).  The Rule treats as “eligible” for FINRA arbitration claims arising out of “occurrences” not more than six years preceding the initiation of a case, but FINRA’s 2012 Arbitrator’s Guide notes that such an event may occur, say, ten years after securities at issue were acquired.  FINRA’s recent amendment to its “fundamental” Rule 2111 on “Suitability” recognizes that a broker’s advice to “hold” previously acquired securities may be a part of a “strategy” created or followed by the broker.  We find that BT’s advice to RLC that claimants buy in 2006 and hold in 2007 was sufficient to avoid application of Rule 12206 to their Complaint filed in 2011.  A rule measured solely from the acquisition of securities makes little sense in the real world in which a customer may well be satisfied for years to hold recommended securities but regards as inappropriate or worse the advice to buy more, hold or sell thereafter.  Claimants had no viable claims during the early years of their holding and could not have claimed damages.  Their claims are essentially based on what they regard as ill-advised recommendations from BT in and his employer’s inadequate disclosures about the risks inherent in the MK funds’ asset bases.  These occurred within the six years preceding the filing of the case.  We hold Claimants’ claims are “eligible” for review by this FINRA Panel.


     The “continuing occurrence or event” exception was adopted by FINRA drawing from federal case law which recognized that for ongoing wrongful acts or omission, the purchase date of an investment does not always trigger the running of the six year eligibility period.  Osler v. Ware, 114 F.3d 91, 93 (6th Cir. 1997) (holding that for a claim of churning, the occurrence or event giving rise to the dispute was when the trading became excessive, not when the initial investments were made.


    Thus, in cases involving claims of ongoing wrongful acts or omissions after the purchase of securities, the “occurrence or event” giving rise to a claim under the NASD Code is the last occurrence or event necessary to make the claim viable.  Kidder Peabody and Co. v. Brandt, 131 F.3d 1001,1004 (11th Cir. 1997); Howsam v. Dean Witter reynolds, Inc. Case No. 05-cv-00911, District of CO (12-21-2005) and Howsom v. Dean Witter Reynolds, Inc. FINRA Case No. 97-01394.


     The Decision in “Howsam” provides a good basis for not using the purchase date.   There, claimant’s husband opened a securities account with Dean Witter in 1986 and purchased four limited partnership investments for approximately $550,000.  The partnership investments (two of which were underwritten by Dean Witter) were represented as long-term investments that would provide growth and income and value for five to twelve year periods.  From 1986 to 1992, certain of the partnerships were not listed on the Dean Witter monthly account statements but representatives of Dean Witter assured the customer the investments were being monitored and they continued to hold their value.  by 1994, claimant learned that the value of the partnerships had eroded.  Claimant filed her NASD arbitration claim in 1997, 11 years after the investments were purchased.  Dean Witter argued that the claim was ineligible for arbitration pursuant to the Six Year Eligibility Rule.  The arbitration panel disagreed on the basis that Dean Witter’s conduct of monitoring and reporting constituted ongoing wrongful acts or omissions which spilled into the six-year period immediately preceding the assertion by claimant of her claims.  Claimant was awarded compensatory damages of $1,342,267.61 inclusive of interest.  The District Court of CO confirmed the Arbitration Award in its Order dated 12-21-2005 (Mason A. Dinehart III, RFC acted as expert witness in the case).


     In Gates v. Horner, Townsend & Kent, Inc., NASD Case No. 06-02833, a Panel rejected the argument that six years had elapsed from the purchase of a variable annuity product because the respondent had continuing duties to provide investment advice with respect to the suitability and investment selections in the variable annuity product sold through respondent to the claimant that he reasonably relied upon at the time of the initial investment was made and thereafter.  The Panel thus found respondent was liable for the initial investment advice, the failure to monitor, the failure to suggest on a timely basis, appropriate adjustments in the allocation of claimant’s holdings and the negligence in continuing management.


        Had the authors of Rule 12206 intended a bright line rule that the purchase of a security  is the triggering occurrence or event giving rise to a claim against the broker, they could easily have said so.  A New York trial court has written:


     The effect of this interpretation in fraud cases is to reward the unscrupulous broker-dealer and to penalize the unsophisticated investor who does not discover the fraud for more than 6 hears after the investment was purchased.  Goldberg v. Parker,1995 W.L. 396568 *2 (N.Y. Sup. Ct., 1995), aff’d, 634 N.Y.S.2d 81 (N.Y.App. Div. 1st Dept. 1995).


     In FSC Sec. Corp. v. Freel, 811 F. Supp. 439, 444 & n.6 (D.Minn. 1993), aff’d 14 F.3d 1310 (8th Cir. 1994) the court agreed that events starting the Rule 10304 clock are not necessarily initial purchases of a security, but frequently are later events in the investment process.


     Post-purchase events may be arbitrable occurrences or events under Rule 10304.  For example, the United States court of Appeals for the Third Circuit in PaineWebber, Inc. v. Hofmann, 984 F.2d 1372 (3rd Cir. 1993), found that active concealment of similar acts of wrongdoing could be events or occurrences under Rule 10304.  As an example of how this analysis would work, consider Hofmann’s claim that PaineWebber actively concealed Faragalli’s wrongdoing… [T]his can also be viewed as an independent cause of action based on a duty owed by PaineWebber to its customers to inform them of a broker’s wrongdoing or of the unsuitably speculative nature of their investments…. In this type of situation, the court must assume for the purposes of determining arbitrability that such a duty is owed.  Id. at 1381.  Similarly, in Merrill Lynch, Pierce, Fenner & Smith v. Cohen, 52 F.3d 381, 385 (11th Cir. 1995), the court stated that “if the [investors] prove that Merrill Lynch reported false values for their investments through bogus statements, then Merrill Lynch’s act of sending the false statements, rather than the initial purchase of the investments, may be the occurrence of event giving rise to their claim.”    Osler v. Ware, 114 F.3d 91,93 (6th Cir. 1997), the court stated, “[a] though counsel for [the broker] contended. . . that the only relevant date for determining whether a claim is time-barred is when the initial investment was made, this theory does not comport with either the “occurrence or event” language contained in [Rule 10304] or the case law that has developed thereunder.”  The Eleventh Circuit has observed that for investments which have a latent defect not immediately causing damages, strict application of a six-year rule could “render some claims ineligible for arbitration before they even come into existence.”  Brandt,  131 F.3d at 1001.  A claim is viable when all the elements of that claim can be established such that it could withstand a motion to dismiss for failure to state a claim for relief pursuant to Federal Rule of Civil Procedure 12(b) (6).”  Logically, the six-year period can only begin to run when a claim accrues or is ripe for litigation.  Prior to that time, there is no claim to be brought.  The court concluded in such cases that the event or occurrence giving rise to the dispute for purposes of Rule 10304 would be the final injury or damages, not the initial purchase.


     An additional post-purchase event that often occurs is the repeated assurances by brokers that the client’s investments remain valuable, will recover losses and the brokers’ advice to hold on to them.  In J.E.Liss, 203 F.3d 848,852 (7th Cir. 2000), the court held that such an allegation was “of an independent fraud designed . . . . to dissuade [the investor] from selling his investment.”


       In at least three cases, the current director of Arbitration of the NASD, deciding threshold issues has ruled the `purchase date was not the event or occurrence that gave rise’ to the dispute . . . . In a letter dated October 28, 1991, the Director stated:  “It has been determined that the purchase date is not the event or occurrence that gave rise to this dispute.  Also, [Rule 10304] does not refer specifically to the purchase date as the time that the six year limitation begins to run.  Therefore, it is equally appropriate that the discovery by the claimant be treated as the occurrence or event giving rise to the dispute. . . .


     There are several sample letters from the NASD to counsel dated July 26, 1991, October 28, 1991, September 27, 1991, October 20, 1002, and January 16, 1993.  The July 26, 1991 letter from Sara Giambona to Theodore F. Brill specifically states, “[a] lso, [Rule 10304] does not refer specifically to the purchase date as the time that the six-year limitation begins to run.  Therefore, it is equally appropriate that the discovery by the claimant be treated as the occurrence or event giving rise to the dispute.”  Emphasis added.  The same language is used in the October 28, 1991, letter from Deborah Masuscci, Esq., Director of Arbitration.  The October 20, 1992 memorandum from Donald Burney, an NASD legal assistant, refers to an allegation of “fraudulent concealment by the respondents which prevented the claimant from discovering wrongdoing until 1989”  and concludes that the case should proceed because “the allegations of continuing fraud fall within the eligibility requirements of [rule 10304] . . . .”  Ms. Masucci’s letter of January 16, 1993, also says that the date claimants learn of continued misrepresentation and/or fraudulent inducement was the triggering date for timeliness purposes.


     Further,  courts have recognized that the sis-year period may be tolled or may begin to run at the time of discovery of the injury and its cause.  In PaineWebber, Inc. v. Landay, 903 F. Supp. 193, 202 (D.Mass. 1995) the court concluded, “I find nothing either in the terms of the parties’ agreement or in Section [10304] itself which compels the conclusion that issues of ‘tolling’ are precluded from consideration under Section [10304]’s six-year eligibility requirement.  Also, PaineWebber, Inc. v. Hoffman, 984 F. 2d 1372 (3d Cir. 1993), acknowledges that there are a number of ‘occurrences or events” which may cause the six-year period to begin to run;  (1) Faragalli’s advice to ‘hold’ all EECO stock — each time this advice was given being an actionable occurrence; (2) Painewebber’s active concealment of Faragalli’s wrongdoing and of the undue speculative nature of Hofmann’s portfolio — the concealment being an independent, actionable wrong; (3) Hoffmann’s discovery of PaineWebber’s and Faragalli’s wrongdoing — the date of discovery being the first date on which Hofmann could prevent further injury;  (4) the continuation of an integrated pattern of wrongdoing — the fraudulent inducement to buy and hold the EECO stock over the period from 1982 through 1991, constituting a single, ongoing wrong; and (5)  the continuation of a wrongful brokerage relationship — the entire brokerage relationship being so tainted with fraud and mismanagement that the relationship itself contsitutes a single actionable wrong.  In Colorado, the cause of action does not accrue until “both the injury and its cause are known or should have been known by the exercise of reasonable diligence.”  # 13-80-108 (1) C.R.S.  Also in Merrill Lynch, Pierce, Fenner & Smith v. Masland, 896 F. Supp. 396, 399 (M.D. Pa. 1995), contains the following statement:  “If Merrill Lynch owed Masland a duty to disclose the risk of his investments and actively concealed the high risk nature of the investments during the six year period before the statement of claim was filed, the claim is arbitrable.  That is, if the concealment of the risk is an ‘occurrence or event’ giving rise to a claim, then the fact that the statement of claim reflects that the concealment occurred within six years of the filing of the statement of claim makes the claim arbitrable.  In Smith Barney Shearson, Inc. v. Boone, 47 F.3d 750, 754 (5th Cir. 1995), the court held that the arbitrators were to resolve the issue of when the six years began to run, whether at the purchase date or at some later time due to subsequent fraudulent acts which prevented the investors from discovering important facts about their claims.  This is known as “continuing fraud” and if it goes on within a period of six years from the time the claim is filed, the claim is eligible to be arbitrated.


     An Eleventh Circuit decision held that under Section 15, the “occurrence or event” which gives rise to the ,,,claim” is the last occurrence or event necessary to make the claim viable.  A claim is viable when all the elements of that claim can be established such that it could withstand a motion to dismiss for failure to state a claim for relief pursuant to Federal Rule of Civil Procedure 12(b)(6).  The District Court of the Eastern District of Virginia recognized that while the purchase date of an investment will often be the relevant occurrence or event giving rise to the claim, “No persuasive authority holds that the purchase must be the ‘occurrence or event'”.  Additionally, the court stated: “in cases considering the purchase as the relevant event, it is unclear whether customers asserted any claims except for the purchase of the contested investment.”  Moreover, the  court reasoned that it was not the NASD’s intention to create a per se rule that the occurrence or event giving rise to a dispute is always the purchase date of a security as follows:                                                                                     Clearly, the drafters of the NASD Code could have provided that claims be brought for arbitration within six years of the purchase of the disputed investment.  Their quite different choice of language is telling, and belies any conclusion that an “occurrence or event” is [not] necessarily the date of purchase.


     In addition to these examples, the arbitration panel in Barry Burges v. Morgan Stanley & Co., Inc., FINRA Case No. 10-00040, recognized a “continuing” occurrence or event giving rise to the dispute under FINRA Rule 12206, even though the “continuing” occurrence or event was not the issue in that case, as follows:


     “Where, however, the claim alleges churning, fraud, or other ongoing activity by the respondent (or respondent’s agent), courts and arbitrators have held that the six years does not begin to run until the conclusion of the wrongful activity.  This has been extended to the very last day of the parties’ association”.




     With regards to statutes of limitations, The Sarbanes-Oxley Act expanded the statute of limitations for federal securities fraud from 1 year/3 years to 2 years/5 years.  It states that a federal securities claim may be brought not later than the earlier of a) 2 years after the discovery of the facts constituting the violation or b) 5 years after the violation.  Section 804 of the Sarbanes-Oxley Act of 2002, 28 U.S.C. # 1658 states that, “claims are barred if brought more than two years after the claimant first was aware of facts that should have caused him to inquire into and pursue any claims of wrongdoing”.


     What happens, however, if the cause of action for the controversy i.e. fraud. unsuitability, breach of fiduciary began well before the 6 year eligibility period begins?  Many times in arbitration, customer accounts at issue begin several years before a date, six years prior to the filing of the statement of claim.  Claimants are not entitled to losses that occurred prior to that date (six years prior to the filing of the S.O.C.).  Likewise, respondents are not entitled to profits that occurred prior to the six-year cut-off.  This is because both these profits and losses are outside the eligibility period.  This is true even though an account relationship with the brokerage firm began earlier or 7 – 10 years prior to the statement of claim filing.


     In situations like these, a positive (or negative) account balance should start the net-out-of-pocket account analysis at month end, six years prior to the date the statement of claim was filed.  It would not be equitable to either claimant or respondent to start the account analysis with a zero balance.  If that were done, then the gains and/or losses on the securities held at the beginning of the analysis could be inaccurate.  At  the beginning date, all securities held should be valued as of the date the analysis begins.  Since arbitration is a court of equity, the starting number should be the actual account balance on the beginning date of the analysis to be fair to all parties, concerned.


     Experience with several arbitration panels has taught me that many arbitrators also appreciate seeing the results over the lifespan of the entire account relationship, even beyond the six years.  Consequently, it is important to provide two analyses.  One going back 6 years and another dating from the actual opining of the account.  By applying well managed theory damages from both dates, you will have two sets of numbers which should reflect damages in the account(s), even if the account made money from inception.






                                                 AUCTION RATE SECURITIES FAILURES




     Failures and declines of auction-rate securities have been occurring since February of 2008.  It is important to understand this obscure corner of the municipals  market.


     Auction Rate Securities are debt instruments (corporate or municipal) with a long-term nominal maturity for which the interest rate is reset through an auction.  These may also included auction-rate preferred or municipal auction rate securities.   The market for auction-rate bonds includes both taxable and tax-exempt instruments.  These are  long-term bonds, maturing in 1- to 20 years, most rated AAA, that have a floating rate of interest.  Unlike conventional bonds, the interest rate is not fixed but rather reset periodically.  The mechanism for changing the interest rate on these bonds is auctions held periodically (from 7 to 28 days) by the bond underwriter.  The auctions have an additional function, which is to match buyers and sellers.  These are so-called Dutch auctions, which means that the interest rate is reset at the lowest rate that results in a sale of all the bonds.  These auctions are not a new phenomenon:  they have been going on successfully for 20 years or so.


     Municipal auction-rate bonds had two categories of clients:  large institutional clients and high net worth individual investors that were managing cash; and closed-end funds, that were using auction-rate bonds to issue preferred stocks, which are used as leverage to boost the dividend interest of the closed-end fund common shareholders.  The minimum denomination of auction rates is $25,000 but historically, most ARS holders are institutional investors and high-net-worth individuals.  Some negative aspects of ARS include lower liquidity and potential drops in the coupon rate.


     The attraction of these bonds to issuers is that they can raise money at short-term rates, and presumably at a lower cost than would be the case if the bonds were financed at longer-term fixed rates, assuming a normal upward sloping yield curve.  Investors in these bonds believed that the bonds were highly liquid – that they could sell the bonds at any upcoming auction, and therefore that the bonds were equivalent to cash.  But in the meantime, they would be earning rates that were somewhat higher than money market rates.  Because of the reset, the bonds were always priced at face value.


     What if there were not enough bids for the auction to be complete?


     In that case, the bond prospectuses stipulated that the would-be sellers would be unable to sell their bonds, but in that event a predetermined penalty rate was to be paid by the issuers.  However, it is likely that many of the buyers were not aware of this fact.  That may be due, in part, to the fact that since these auctions began, in order to make sure auctions did not fail, the agents conducting the auction (usually large investment banks or brokers) stepped in and bought enough bonds so that the auction was successful.  It is also possible that the risk of auction failures was not fully disclosed.


     As far back as 2006, problems began cropping up in the auction-rate market.  Auditing firms had issued a ruling that auction-rate securities could not be classified as “cash”, and some institutional investors began exiting the market.  These auctions, however, were quite lucrative to the auction agents, who both underwrote the instruments and conducted the auctions.  In order to expand potential buyers, the minimum investment was lowered from $250,000 to $25,000, which attracted individual investors.  Auction-rate bonds continued to be sold as highly liquid, almost money market equivalents.  But the picture changed dramatically in 2008


     In late January, an auction failed because the auction failed to step in and buy the bonds.  Suddenly, there were only sellers and no buyers.  Subsequently, auction failures became widespread as other banks, faced with mounting losses in other portfolios, refused to add auction-rate bonds to their declining balance sheets.


     As stipulated in the prospectus, when an auction fails, holders of auction-rate bonds are paid a penalty rate stipulated in the contract for these bonds.  However, their holdings are suddenly frozen until the final maturity date of the bonds.  In effect, what they have thought of as the equivalent of cash suddenly becomes long-term bonds.  (Even worse, some of the bonds issued by closed-end funds are perpetuals!)  Neither the issuers, nor the auction agents running the auctions, are in any way obligated to redeem the bonds until the final maturity date.  For investors who currently hold auction-rate bonds, and who would like to cash out, whether they hold muni’s or taxable bonds, the immediate picture is cloudy.  Interests of issuers of auction-rate bonds vary widely and those will dictate whether or not they attempt to enable holders of auction-rate instruments to cash out.


     One avenue available to issuers of municipals is that they can call the bonds and refinance them at fixed rates.  Issuers who are paying high penalty rates clearly have an incentive to refinance.  But if the penalty rate is low, it may still be cheaper to continue to pay the penalty rate than to redeem the paper and reissue it at higher fixed rates.


     For closed-end funds, which used auction-rate bonds to issue preferred shares, the situation is more complex.  The interests of the holders of the closed-end fund preferred shares and those of the common shareholders of the fund conflict.  The closed-end funds used auction-rate bonds as a way to obtain cheap financing to create leverage.  One option available to the closed-end funds is to redeem the auction-rate bonds and find an alternative vehicle (a bank loan, for example) for issuing new preferred shares.  But to the extent that refinancing the preferred is more expensive than the auction-rate bonds, this creates a conflict of interest because liquidating the auction-rate paper translates into lower income for the common shareholders.  The really bad news for holders of preferred shares is that, in come instances, the penalty rates are so low that is is cheaper to keep on paying them than to find an alternative vehicle to create leverage.


     Nonetheless, there are ongoing efforts to create some liquidity.  Several brokerage firms are allowing clients to take out loans, using the auction-rate bonds as collateral (unfortunately, at rates higher than the interest they are getting!).  Several firms are also trying to develop methods of repackaging auction-rate bonds in order to make them eligible for purchase by money market funds.  But this avenue involves legal and regulatory complexities and will take some time to work out.


     A totally different approach involves the attempt to create a secondary market for the frozen auction-rate bonds.  This, too, is proving difficult – holders of these instruments want to sell at face value.  But given the current lack of liquidity, potential buyers want to buy at a significant discount,  perhaps 10 to 20%.  So far, there have been few reports of actual trades occurring.


     One additional note:  Andrew Cuomo, the attorney general of the state of New York, is opening an investigation to determine whether irregularities were committed by auction agents in selling the bonds – for example, whether risks were fully disclosed, and whether some customers were allowed to cash out while others were not.  Regulators in other states may follow suit.


     The collapse of the roughly $330 billion auction-rate securities market this year was fueled by a lack of transparency and may have been avoided if investors had a comprehensive source for disclosures that showed the extent to which successful auctions were dependent on broker-dealer intervention, the Securities and Exchange Commission’s municipal securities chief, Martha Mahan Haines stated on June 2, 2008.  Ms. Haines said that one of the biggest problems in the ARS market was its opacity, which may have kept investors from knowing that a small group of broker-dealer firms that bid on the auctions were critical to preventing widespread failures.  Even though broker-dealers disclosed that they were bidding on auctions, the extent of their participation was unknown, she said.


     “If investors could see that broker-dealers were so active in this market…perhaps it wouldn’t have grown so large, well beyond the broker-dealer’s ability to hold it up, “Haines said, speaking at the Securities Industry and Financial Markets Associations legal and compliance conference in New York.  “We may not have gotten into this mess had there been transparency.”


     Haines’ remarks come as the Municipal Securities Rulemaking Board is considering establishing a centralized system for the collection and dissemination of critical market information about both auction-rate securities and variable-debt obligations, which are considered short-term securities.


     Haines’ remarks were echoed by John Cross III, an attorney with the Treasury Department’s office of tax policy, who said that there is a lack of basic information about auction-rate securities that likely confused many investors.  At a fundamental level, he said, market participants did not understand the difference between auction-rate securities – which have no liquidity facilities but were nonetheless widely considered highly liquid, short-term investments – and money-market eligible VRDO’s (variable-rate debt obligations) which have liquidity facilities and are thus eligible for investment by money-market funds under the SEC’s Rule 2A-7.


     Liquidity facilities include lines of credit, standby bond purchase agreements, or other arrangements in which an entity, typically a bank, promises to purchase securities that cannot be immediately sold or remarketed to new investors.  Demand for ARS was fueled at least in part by the fact that they were cheaper than VRDO’s, which usually include pricey letters of credit, he said.  “One of the biggest, broadest themes right now is basically efforts to dress up auction-rate securities so that they have liquidity facilities so that they can be sold to the money market funds, “Cross said, referring to the push by issuers to convert their ARS to VRDO’s or fixed-rate bonds.  “That unfortunately comes at a time when the financial positions and balance sheets of all the banks are equally challenged and the silver bullet of adding liquidity facilities…still faces ongoing business challenges.


     In February,2008, investors stopped buying ARS following ratings downgrades of bond insurers that backed them and the auctions held to periodically reset the rates began to fail when they did not attract enough buyers.


     In the past, banks and broker-dealers put in bids of their own for these securities to prevent auctions from failing.  But in June 2006, 15 firms agreed to pay $13 million to settle charges that they violated the securities laws by not disclosing these and other auction-rate securities practices.  Some firms began disclosing their practice of putting in bids to prevent auctions from failing.  But the credit crunch led banks and dealers to tighten their lending standards and in February, they stopped bidding on auctions.


     Meanwhile, Haines said she expected that the SEC would soon propose changes to its Rule 15c2-12 on disclosure that would designate the MSRB’s Electronic Municipal Market Access, or EMMA system, as the central repository for secondary market disclosures.  The long-anticipated rule change would replace the four existing nationally recognized municipal securities information repositories with EMMA.  Previously, SEC Chairman Christopher Cox has said that the proposed rule change would come out in May, but Haines said that the delay is attributable to the care with which the proposal is being crafted.


     “The commission staff has taken the internal view that its better to do it slow and to do it right the first time than to get something out fast that’s not right and that you have to go back and fix, “she said.


     While much has been made of municipalities’ and many closed end-funds’ successful efforts and continuing efforts to provide investors liquidity, those ARS purchasers with student-loan trusts and collateralized debt obligations (CDO’s) still have much to be concerned about.  A recent article by Barron’s provided the following ‘outlook” for student loan ARS:  “Absent a government bailout, these are likely to stay outstanding.  Similarly, the outlook for CDO’s is likely to remain outstanding”. That’s unfortunate.  The two types of ARS are, in reality, 30 – 40 year notes! Attorneys continue to investigate and counsel investors in how best to extricate themselves from this debacle.


     On June 26th, Massachusetts securities regulators sued UBS Securities and UBS Financial Services for their role in the action rate securities (“ARS”) debacle that has plagued not only UBS but several other financial services firms.  In addition to other relief, the 101- page  complaint seeks an order requiring UBS to offer to rescind sales of ARS at par (purchase price)  or to offer restitution to investors who already sold their ARS below par.


     Much like the emails that Eliot Spitzer uncovered to expose Wall Street’s widespread undisclosed conflicts of interest in the research analyst cases,  Massachusetts securities regulators have uncovered scores of emails from UBS executives that make UBS’ denial of liability border on the laughable if not the absurd.


     Consider the more important changes that Massachusetts securities regulators have lodged against UBS.  First, “typically” UBS sold ARS to investors as “liquid, safe money-market instruments”, and UBS’ marketing materials promoted and classified ARS as “Cash and Cash Alternatives Addressing our short-term needs” through February, 2008.  Additionally, UBS listed ARS on client statements under the titles “cash alternatives/money market instruments”.  Investors, according to the  complaint, were told that interest rates were set in periodic auctions, and that either the ARS “were readily tradable in auctions” which typically occurred every 7 or 28 days, or that the instruments “matured” in 7 or 28 days.  However, the truth (or material omission) was quite contrary to the oral and written representations.  According to the complaint, investors were not informed that:


     *  UBS submitted a support bid for every suction for which it was the lead or sole broker-dealer to ensure that the auction would not fail;


     *  UBS, in August, 2007, intentionally let certain auctions fail because there were not sufficient buyers and UBS did not want to own more of the ARS paper that it had been trying to auction off;


     *  UBS offered only the ARS products that it had underwritten and was trying to distribute; and


     *UBS itself set the interest rate in most of the auctions with the bids it submitted, to actively manage the interest rates so that they would be just high enough to move the ARS it had underwritten but not so high as to make the issuers that were its underwriting clients unhappy.


     Second, the complaint alleges that UBS’ clients “were also in the dark concerning the dangerous increase in auction rate security inventory that UBS was carrying on its books beginning during the Fall of 2007 and continuing through to February, 2008.”  Indeed, UBS failed to inform clients that:


     *  UBS’ short-term trading desk had exceeded, multiple times in 2007 and early 2008, the amount of capital it was authorized to support the auctions and repeatedly had to request an increase in that cap;


     *  UBS engaged in “extreme efforts” to decrease its inventory of ARS at the insistence of its risk management department;


     *  UBS, as early as September 2007, “was actively considering scenarios which included pulling out of its auction program altogether”; and


     *By the end of October, 2007, David Shulman (Global Head Municipal Securities Group and Head of Fixed Income Americas at UBS Securities) described the auction rate program as “a huge albatross”, and in a December 11th email, stated that “auctions aren’t going to come back”.


     Third, to alleviate the “enormous amount of stress” that UBS’ auction rate program was experiencing, given the buildup of its ARS inventory, the complaint alleges that UBS orchestrated a major marketing push to convince unsuspecting retail investors to buy ARS from UBS’ inventory.  Indeed, the Complaint alleges that Shulman himself  “orchestrated an all-out sales effort in order to get retail customers to see the ‘value’ in ARS at the prices at which UBS was willing to offer them” – all the while that Shulman was selling his own ARS holdings!  In that regard, Massachusetts regulators “uncovered a profound disconnect between UBS’ understanding of the ARS it was selling and the FA’s (financial advisers’) explanations of these securities to their customers.”  UBS continued to promote the sale and did sell ARS to its customers right up until the day that it decided to abandon its auction rate program, February 13, 2008.


     The Securities and Exchange Commission filed a Civil Action on December 11, 2008 against Citigroup before Judge Berman in the U.S. District Court – Southern District of New York.  In the case the SEC alleges that Citigroup misled tens of thousands of its customers regarding the fundamental nature and increasing risks associated with auction rate securities (ARS) that Citi underwrote, marketed and sold.  Through its financial advisers, sales personnel, and marketing materials, Citi misrepresented to customers that ARS were safe, highly liquid investments comparable to money market instruments.  Through its financial advisers and sales personnel, Citi marketed ARS to its customers as money market alternatives and liquid investments that could be liquidated at the customer’s demand on the nest auction date.   In many cases, the complaint alleges, Citi did not adequately advise these and other customers that, under certain circumstances, any funds invested in ARS could become illiquid, possibly for long periods.  Especially of concern was the fact that monthly account statements sent to Citi customers listed certain types of ARS under the heading “money market and auction instruments.”  Citi’s association of ARS with money market alternatives was misleading because of the illiquidity risks associated with ARS.  Further, Citi’s disclosures regarding auction failures, however, were inconsistent with its dexcription of ARS as “an alternative to money market funds” and inconsistent with its marketing of ARS as liquid, short-term investments.  Finally, beginning in 2008, to accommodate Citi’s inventory of ARS, as it increased from approximately $4 billion to more than $10 billion in February, 2008 when Citi stopped supporting auctions.  When Citi discussed the possibility of failed auctions, Citi often stated that ARS have high, above market, maximum rate resets if an auction failed, to compensate the holder for the lack of liquidity and to create incentives for the issuer to restructure the ARS, thereby providing liquidity to the holder.  Citi failed to disclose that, at least under market conditions at the time, certain ARS had low, below market, maximum rate resets.  The complaint alleges that Citi again misled investors by telling them, “There are a smaller number of issues with low reset rates.  Even here, many of the issues are either backed by a strong issuer, guaranteed by a strong issuer, or in the process of being wrapped by a strong guarantor”.  Citi also knew or was reckless in not knowing that its retail customers expected liquidity on demand and that Citi-managed auctions historically had provided that liquidity.


     As a result of abuses in this area, FINRA issued Notice to Members 08-82 in December, 2008.  The notice charges its securities firm members to avoid overstating a product’s similarities to a cash holding or “cash alternatives” and provide balanced disclosure of the risks and returns associated with a particular product.  It states, “Firms may not claim that a product is an alternative to cash unless the statement is fair and accurate”.  Further, the fact that a firm intends to describe an investment as a cash alternative only to institutional investors does not relieve the firm of its responsibility to conduct due diligence and a reasonable-basis suitability analysis.  In the case of a cash alternative, training should encourage extreme caution in characterizing a product to an investor as an alternative to cash.  Examples of cash alternatives include:  auction rate securities, bank certificates of deposit, bank money market accounts, commercial paper, floating rate funds, guaranteed investment contracts, money market mutual funds, repos and swaps, structured investment vehicles, Treasury bills, ultra-short bond mutual funds, and variable rate demand notes.  FINRA notes that while many of those investments are well-known, others are not.  Recent experience with auction rate securities is an example.  According to FINRA, “many investors who believed their auction rate securities holdings to be almost as conservative and liquid as cash found themselves with illiquid holdings of uncertain value.”




      Margin borrowing to buy stocks is very risky and should be avoided at all costs.  That is the opinion of former SEC Commissioner Arthur Levitt.  Margin involves buying a security but not paying for it in full, instead obtaining a loan from the brokerage firm and using the security as collateral for that loan.  One significant risk of margin borrowing occurs when the price of the security falls.  If there is a “margin call” (whereby the brokerage firm demands more collateral to be deposited in the account), the investor must comply.  Otherwise, the brokerage firm will exercise its right to sell the security.  that involuntary sale can result in substantial losses.  The “power of leverage”, a sales pitch often made to encourage margin use, quickly turns against the investor, who possibly would have chosen to hold the security hoping for a rebound.

      Why do stockbrokers and their firms promote the use of margin?  There are several reasons.  First, in commission-based accounts, margin allows additional purchases, which generate additional commissions.  Second, in fee-based accounts (where the investor pays the stockbroker a percentage of the value of the account in lieu of commissions), the use of margin increases the value of the account, thereby increasing the compensation paid to the stockbroker.  Third, stockbrokers may receive a portion of their customers’ margin interest as additional compensation.  Fourth, brokerage firm branch managers may receive margin interest “credits” for purposes of determining branch office profit, and hence branch manager compensation.  See in the Matter of Stephen Thorlief Rangen, Securities Exchange Act Rel. No. 38486 (April 8, 1997), where the SEC stated that “[t]rading on margin increases the risk of loss to a customer for two reasons.  First, the customer is at risk to lose more than the amount invested if the value of the security depreciates sufficiently, giving rise to a margin call in the account.  Second, the client is required to pay interest on the margin loan, adding to the investor’s cost of maintaining the account and increasing the amount which his investment must appreciate before the customer realizes a net gain.  At the same time, using margin permit[s] the customers to purchase greater amounts of securities, thereby generating increased commissions for [the broker].”

      Investors should heed the warnings of securities regulators.  Both the SEC and the NASD have issued several publications on the topic of margin investing.  For example, the SEC has cautioned that margin accounts involve “a great deal more risk than cash (non-margin) accounts”.  The SEC tells investors to ask themselves four key questions

     *  Can you afford to lose more money than the amount you have invested?

     *  Did you read the margin agreement and ask your broker whether margin trading is appropriate for you?

     *  Do you know that margin costs you money and that these costs affect your overall return?

     *  Are you aware that brokerage firms can sell your securities without notice when you do not have sufficient equity in your account?

      The NASD has warned that some brokerage firms automatically open margin accounts for investors unless they affirmatively opt out from having this credit line.  The NASD stresses that if an investor does not want a margin account, insist on opening only a cash account.  In September, the NASD issued an alert to investors because investors’ purchases on margin “have grown dramatically” – 25% since the start of 2003.  The alert states that “many investors may underestimate the risks associated with trading on margin and misunderstand margin calls and how their holdings can be liquidated.  Accordingly, investors must educate themselves as to the risks associated with purchasing securities on margin”.

      It is very important to note that brokerage firms are required by NASD Rule 3010 and NYSE Rule 342 to review all activity in customers’ accounts, perform periodic reviews of customer account statements, review exception reports for excessive activity and turnover, and review and approve all new account applications and margin agreements.

      In recent rule-making and subsequent guidance to its members regarding margin accounts, the NASD has issued Rule 2341 and related Notice to Members 01-31, establishing the requirement for annual disclosure of the features of margin accounts.

      Qualified margin customers are those customers  that exhibit adequate financial and credit resources to absorb an increased risk of loss, prior investment history in marginable stocks, and financial investment sophistication to adequately evaluate the inherent risks of margin trading.  A client must have the wherewithal  to pay for any trade at the time it is executed whether it is entered in a cash or margin account.  Margin accounts should be reserved only for those clients who fully understand the nature of the account, and who can bear the responsibility and increased risk.


     Margin increases risk and that risk can exceed the amount of the investor’s funds invested if the stock(s) purchased on margin decline in value below the amount of the margin loan.*  While margin increases the risk proportional to the percentage of margin used when engaged in a buy and hold strategy,** the use of margin for a market trading strategy increases risk disproportionately so that any loss experienced for any one period requires a dramatically greater return for the next period.***

 *  For example, if 1,000 shares of a security are purchased at $100 per share for a total of $100,000 with the customer depositing $50,000, the customer owes the brokerage firm $50,000.  If the price of the security falls to $450 per share, the liquidating value of the security position is $40,000 leaving a $10,000 debit balance oweing the brokerage firm.  The customer has invested $50,000 but lost $60,000.

 ** Using a 50% margin level permits an investor to buy twice as many shares and double his/her profits or losses.  A 25% margin level permits the investor to purchase 50% more shares thereby increasing his/her profits or losses by 100%.

 *** An investor who uses $100,000 in a trading strategy and who loses 10% experiences a $10,000 loss and would require realizing 11% in profits during the next period to break even (111% times $90,000 = $100,000).  However, the investor who uses 50% margin would have placed $200,000 at risk and lost $20,000 leaving him/her with $80,000 in capital after repaying the margin loan upon liquidation of the positions.  This investor now requires a 25% return to break even.


Broker Dealers are also charged with the following margin responsibilities:


B/D’s are prohibited from exceeding the prescribed limit on margin debt.

B/D’s are required to liquidate margin excesses of the client .

Customers have no contributory liability.



Exceeding Margin debt.

Rule 10b-16 and Regulation T (12 CFR ## 220.3(e), 220.8) also strictly prohibit a broker or dealer from exceeding prescribed margin limits and require a broker or dealer to promptly liquidate any margin debt exceeding these limits in an account by the fifth business day after its incurrence.  Shearson Lehman Brothers v. M & L Investments, 10  F. 3d 1510, 1513 (10th Cir. 1993); Robertson v. Dean Witter, supra, 749  F.2d at p. 534; Naftalin v. Merrill Lynch, supra,  469  F.2d at p. 1176; Avery v. Merrill Lynch, supra,  328  F. Supp. at p. 681.

     Brokers and dealers are also liable for exceeding margin limits under Exchange rules, e.g. NYSE Rule 431, ASE Rule 462, etc. which also govern the minimum equity required in margin accounts i.e. 25%.  See, e.g. Evans v. Kerbs & Co.,  411  F. Supp. 616, 619-621 (SD NY 1976).

    Finally, brokers are liable for all losses to their customers resulting from the consequences of excessive margin debt and from their failure to promptly liquidate to cover such debt as required by law.  Robertson v. Dean Witter, supra,  749  F. 2d at p. 534.  Avery v. Merrill Lynch, supra, 328  F. Supp. At p. 681; see also Neill v. David Noyes & Co., supra, 416 F. pp. 79-80;  Evans b. Kervs & Co. , supra, 411  F. Supp. At pp. 621-624;  Spoon v. Walston & Co.,  345  F. Supp. 518, 522  (Ed Mich.

SD 1972).


Failure to Liquidate:

Whenever a client’s account becomes margined in excess of that permitted by federal law or the exchange rules, and whenever there is insufficient equity to cover the unmargined portion of its holdings or an order executed therein for the client, the broker is required by federal law and the exchange rules to liquidate sufficient holdings within 5 business days.  By failing to do so, the broker becomes liable for all resulting losses.  15 U.S.C.  #78g; 12  CFR  ##  220.3(b), (e)  Avery v. Merrill Lynch, supra,  328  F. Supp.  677, 678, 681; see also Naftalin v. Merrill Lynch, supra, 469  F. 2d at pp 1170, 1173, 1176; Neill v. David A. Noyes & Co. supra, 416  F. Supp. At pp. 79-80.

     This liquidation requirement is designed to protect the individual investor.  There is a presumption that brokers are at all times aware of the rules, laws and margin status of each account.  Evans, v. Kerbs & Co., supra, 411  F. Supp. At pp. 620-623.  Even a customer cannot, actively or otherwise, “consent” to waive this requirement to immunize the broker.  Spoon v. Walston & Co. , supra., 345  F. Supp. At pp. 520-522.


Customer has no contributory liability:

“The court concludes that mere participation in or knowledge of  [a violation by the broker or dealer]  without fraud or deceit is not enough to deny the plaintiff recovery [  ]  in our view the danger of permitting a windfall by an unscrupulous investor is outweighed by the salutary policing effect which the threat of private suits for compensatory damages can have upon brokers and dealers above and beyond the threats of governmental action by the SEC [  ]   To allow the broker to plead contributory negligence or causation by the customer as the reason for a violation would remove the very heart of the legislation  [  ]  the duty of the broker is made completely clear.   .   .   “    Avery v. Merrill Lynch, supra,  328 F. Supp. At pp. 680-681.


“The Court will not entertain a cacophony of blame on the part of the brokers and customers – each blaming the other for not meeting the requirements —  the ultimate responsibility must be placed somewhere and congress has indicated that is with the brokers or dealers.”   Spoon v. Walston & Co., supra,  345  F. Supp. At p. 521.


                        “[The purpose of the Act is] protection of the small speculator by

                        making it impossible for him to spread himself too thin   .   .   . “ he

                        enjoys a paternalistic protection if his stockbroker chances to lend

him more than he is allowed to   .   .   .   If damage comes from such foolish speculation of excessive credit, it is the broker who must pay the piper to vindicate the purpose of the statutory controls.   .   .   .”  Bowman v. Hartig,  334 F. Supp.  1323, 1327 (SD NY 1975).


See also Naftalin v. Merrill Lynch, supra,  469  F. 2d  at pp. 1180-1181  [same]; 33 ALR Fed. 626, 656.


   B.  The SEC approved the NASD Rule Proposal requiring delivery of margin disclosure statement to non-institutional customers (NASD Notice to Members 01-21)  SEC approval date 4-26-01


Prior to this time, courts have held that broker dealers have a duty to disclose  the risks, requirements and details of margin trading to inexperienced customers.   Those same courts have held broker dealers liable for losses when they did not make those disclosures:


In Arlington v. Merrill Lynch, supra, 651  F. 2d 615, 617-620, the Court chastised Merrill Lynch for inducing clients with no prior margin trading experience to convert to margin trading without fully disclosing the risks and facts they would need as required by law, resulting in substantial losses to Merrill Lynch’s clients when the value of their securities decreased.  Id, pp. 617-620; see also Robertson v. Dean Witter, supra,  749  F. 2d at p. 539; see Arrington v. Merrill Lynch, supra,  651  F. 2d at p. 620  [Merrill Lynch fails to explain to its clients “the multiplier effect extended margin trading has on a trader’s losses in a declining market”].

     In Evans v. Kervs & Co., supra, 411  F. Supp. At pp. 619-624, the broker informally mis-advised its client as to the percentage of margin permitted, failed to provide the requisite disclosure, and then failed to promptly liquidate as required, devastating the client’s financial position.  The court sustained the action including punitive damages.  Neill v. David A. Noyes & Co. , supra, 416  F. Supp. at pp. 79-82  [same].